“Permanently high estate tax exemptions, portability and higher trust income
tax rates after American Taxpayer Relief Act of 2012 (“ATRA”) force us to
fundamentally rethink trust design, especially for couples with under $10.5
million in assets. This commentary proposes various methods to ensure optimal
basis increases and better ongoing income tax treatment over traditional AB
trust design, including application to existing irrevocable trusts.
Three advantages of the Optimal Basis Increase Trust (OBIT) are examined: 1)
giving the surviving spouse a limited power to appoint, but enabling both the
appointment and the appointive trust to trigger the Delaware Tax Trap over the
appointed assets; 2) giving the surviving spouse a general power to appoint
appreciated assets up to the surviving spouse’s remaining applicable exclusion
amount and 3) ensuring that either method does not cause a "step down" in
basis and is applied for the most efficient increase.”
Now, Ed Morrow provides LISI members with important commentary on
what he refers to as the “Optimal Basis Increase Trust.” As he points out in his
commentary, the OBIT should give substantial financial incentives for clients to
revisit their estate plan. Ed Morrow, J.D., LL.M., CFP®, is an Ohio attorney
and national wealth specialist with Key Private Bank. Portions of his
commentary were presented to the Purposeful Planning Institute’s CLE and
National Business Institute CLE in May 2011.
Here is Ed’s commentary:
EXECUTIVE SUMMARY:
Permanently high estate tax exemptions, portability and higher trust income tax
rates after American Taxpayer Relief Act of 2012 (“ATRA”) force us to
fundamentally rethink trust design, especially for couples with under $10.5
million in assets. This commentary proposes various methods to ensure optimal
basis increases and better ongoing income tax treatment over traditional AB
trust design, including application to existing irrevocable trusts.
FACTS:
“It is not the strongest of the species that survives, nor the most intelligent that
survives. It is the one that is the most adaptable to change.” – Charles Darwin
For many taxpayers, the traditional trust design for married couples is now
obsolete. Gone with the Dodo Bird. This article will explore better planning
methods to maximize basis increase for married couples (and, for future
generations), exploit the newly permanent “portability” provisions, maximize
adaptability to future tax law, enable better long-term income tax savings and
improve asset protection over standard “I love you Wills” and over standard AB
trust planning. Primarily, this article focuses on planning for married couples
whose estates are under $10.5 million, but many of the concepts herein apply to
those with larger estates as well.
First, we’ll describe the main income tax problems with the current design of
most trusts in light of portability and the new tax environment – and problems
with more simplified “outright” estate plans. In Part II, we’ll describe potential
solutions to the basis issue, including the use of various marital trusts (and the
key differences between them), and why these may also be inadequate. In Part
III, we’ll explore how general and limited powers of appointment and the
Delaware Tax Trap can achieve better tax basis adjustments than either outright
bequests or typical marital or bypass trust planning.
I will refer to any trust using these techniques as an Optimal Basis Increase
Trust. In Part IV, we will discuss the tremendous value of applying these
techniques to pre-existing irrevocable trusts. Lastly, in Part V, we’ll discuss
various methods to ensure better ongoing income tax treatment of irrevocable
trusts – not just neutralizing the negatives of trust income taxation, but
exploiting loopholes and efficiencies unavailable to individuals. I will refer to
these two groups of techniques taken together as an Optimal Basis Increase and
Income Tax Efficiency Trust1, features of which are summarized in the chart
that can be seen in this link: Chart
Responding to the Portability Threat -- and Opportunity
The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation
Act of 2010 (“2010 Tax Act”) introduced a profound change to estate planning
that was recently confirmed by the American Taxpayer Relief Act of 2012
(“ATRA”). Section 303 of the 2010 Tax Act, entitled “Applicable Exclusion
Amount Increased by Unused Exclusion Amount of Deceased Spouse”, is
commonly known as “portability”.2 ATRA recently made this provision
permanent, along with a $5,000,000 exemption for estate, gift and generation
skipping transfer tax, adjusted for inflation (even with low inflation, it has
already increased to $5,250,000).3
The concept of portability is simple: the surviving spouse gets any unused estate
tax exclusion of the deceased spouse provided the Form 706 is properly filed.
While it does have various flaws and quirks, portability goes quite far to correct
a basic injustice that would otherwise occur when the beneficiaries of a couple
with no bypass trust planning pay hundreds of thousands (if not millions) more
in estate tax than the beneficiaries of a couple with the same assets who die
without any trust planning.
Portability has been described as both the “death knell” of the AB Trust4 as well
as a “fraud upon the public”.5 Ubiquitous popular financial press articles now
refer to the “dangers” of traditional AB trust planning or the “death of the
bypass trust”. While these charges have some surface justification, they all fail
to see the tremendous income tax opportunities opened up to trusts by the new
law – if trusts are properly adapted.
The lure of portability and a large exemption is indeed a siren song for some
married taxpayers to avoid trusts. Like Odysseus, we should listen to it despite
of our misgivings. The new exemption level, coupled with the advantages of
portability, eliminates what was previously the most easily quantifiable reason
to do trust planning – saving estate tax - for the vast majority of taxpayers.
More than that, however, the new tax environment seemingly deters taxpayers
from using trusts through significant income tax disparities, despite the many
non-tax reasons for using them.
What’s wrong with the traditional AB trust?
1) No Second “Step Up” in Basis for the B Trust for the Next Generation.
Imagine John leaves his wife Jane $3 million in a bypass trust and Jane outlives
him 10 years. Over that time the income is spent but the fair market value has
doubled to $6 million. Jane has her own $3 million in assets. At Jane’s death,
their children inherit assets in the bypass trust with only $3.5 million in basis
(assuming net $500,000 realized gains over depreciation or realized losses).
Had John left his assets to her outright or to a differently designed trust and Jane
elected to use her Deceased Spousal Unused Exclusion Amount (DSUEA), heirs
would receive a new step up in basis to $6 million, potentially saving them
$750,000 or more!6
2) Higher Ongoing Income Tax. Any income trapped in a typical bypass or
marital trust over $11,950 is probably taxed at rates higher than the
beneficiary’s, unless the beneficiary makes over $400,000 ($450,000 married
filing jointly) taxable income. Including the new Medicare surtax, this might be
43.4% for short-term capital gains and ordinary income and 23.8% for long-term
capital gains and qualified dividends. This is a staggering differential for even
an upper-middle class beneficiary who might be subject to only 28% and 15%
rates respectively.
3) Special assets can cause greater tax burden in trust. Assets such as IRAs,
qualified plans, deferred compensation, annuities, principal residences,
qualifying small business stock and S corporations are more problematic and
may get better income tax treatment left outright to a surviving spouse or to a
specially designed trust – retirement plan assets left outright get longer income
tax deferral than assets left in a bypass trust.7 Outright bequests of such assets
get around many problematic “see-through trust” rules and the minefield of
planning and funding trusts with “IRD” (income in respect of a decedent)
assets.8 Other assets, such as a personal residence, have special capital gains tax
exclusions or loss provisions if owned outright or in a grantor trust.9 Ownership
of certain businesses requires special provisions in the trust that are sometimes
overlooked in the drafting, post-mortem administration and/or election stages.10
Yet outright bequests are not nearly as advantageous as using a trust. The best
planning should probably utilize an ongoing trust as well as exploit portability,
which will be discussed in the next section.
Why not just skip the burdens of an ongoing trust?11 Here’s a quick dozen
reasons:
1)
A trust allows the grantor to make certain that the assets are managed and
distributed according to his/her wishes, keeping funds “in the family
bloodline”. Sure, spouses can agree not to disinherit the first decedent’s family,
but it happens all the time – people move away, get sick and get remarried – the
more time passes, the more the likelihood of a surviving spouse remarrying or
changing his or her testamentary disposition.12
2)
Unlike a trust, assets distributed outright have no asset protection from
outside creditors (unless, like an IRA or qualified plan, the asset is protected in
the hands of the new owner) - whereas a bypass trust is ordinarily well-protected
from creditors;
3)
Unlike a trust, assets distributed outright have no asset protection from
subsequent spouses when the surviving spouse remarries. Property might be
transmuted or commingled to be marital/community property with new spouse.
If it is a 401(k) or other ERISA plan, it might be subject to spousal protections
for the new spouse (which cannot be cured via prenup, and become mandatory
after a year of marriage).13 Most states also have spousal support statutes which
require a spouse to support the other - and there is no distinction if it is a second,
third or later marriage. Also, most states have some form of spousal elective
share statutes that could prevent a surviving spouse from leaving assets to
children to the complete exclusion of a new spouse;
4)
Unlike a trust, assets left outright save no STATE estate or inheritance
tax unless a state amends its estate tax system to allow similar DSUEA elections
(don’t hold your breath – none have yet). This savings would be greater in
states with higher exemptions and higher rates of tax, such as Washington State
(19% top rate) or Vermont (16% top tax rate), both with $2 million exemptions.
Assuming growth from $2 million to $3 million and a 16% state estate tax rate,
that savings would be nearly $500,000!
5)
Unlike a bypass trust, income from assets left outright cannot be
“sprayed” to beneficiaries in lower tax brackets, which gets around gift tax
but more importantly for most families can lower overall family income tax –
remember, the 0% tax rate on qualified dividends and long-term capital gains is
still around for lower income taxpayers!
6)
The Deceased Spousal Unused Exclusion Amount (DSUEA), once set, is
not indexed for inflation, whereas the Basic Exclusion Amount (the $5 million)
is so adjusted after 2011 ($5.25 million in 2013). The growth in a bypass trust
remains outside the surviving spouse's estate. This difference can matter
tremendously where the combined assets approximate $10.5 million and the
surviving spouse outlives the decedent by many years, especially if inflation
increases or the portfolio achieves good investment returns;
7)
The DSUEA from the first deceased spouse is lost if the surviving
spouse remarries and survives his/her next spouse’s death (even if last
deceased spouse’s estate had no unused amount and/or made no election). This
result, conceivably costing heirs $2.1 million or more in tax, restrains remarriage
and there is no practical way to use a prenuptial (or postnuptial) agreement to
get around it;
8)
There is no DSUEA or “portability” of the GST exemption. A couple
using a bypass trust can exempt $10.5 million or more from estate/GST forever,
a couple relying on portability alone can only exploit the surviving spouse’s
$5.25 million GST exclusion. This is more important when there are fewer
children, and especially when these fewer children are successful (or marry
successfully) in their own right. For example, a couple has a $10.5 million
estate and leaves everything outright to each other (using DSUEA), then to a
trust for an only child. Half will go to a GST non-exempt trust (usually with a
general power of appointment), which can lead to an additional $5.25 million
added to that child’s estate – perhaps needlessly incurring more than $2 million
in additional estate tax.
9)
Unlike a bypass trust, portability requires the executor to timely and
properly file an estate tax return to exploit the exclusion. This is easy for
non-professional executor/trustees to overlook and lose. Unlike some areas of
tax law, the IRS is not authorized here to grant exceptions or extensions for
reasonable cause;
10) Unlike a bypass trust, outright bequests cannot be structured to better
accommodate incapacity or government benefits (e.g. Medicaid) eligibility
planning;14
11) A bypass trust can exploit the serial marriage loophole. Example:
John Doe dies leaving his wife Jane $5.25 million in a bypass trust. She
remarries and with gift-splitting can now gift $10.5 million tax-free. If husband
#2 dies using no exclusion – Jane can make the DSUEA election and have up to
$10.5 million Applicable Exclusion Amount (AEA), even with the $5.25 million
in the bypass trust John left her, sheltering over $15.75 million (three exclusion
amounts, not adjusting for inflation increases) for their children without any
complex planning, not even counting growth/inflation. Had John and Jane
relied on outright or marital trust, even w/DSUEA, their combined AEA would
be capped at two exclusion amounts ($10.5 million, not adjusting for inflation
increases) – a potential loss of over $2 million in estate tax.
12) Portability only helps when there is a surviving spouse. It may not work
in a simultaneous death situation, whereas a bypass trust with proper funding
or a simultaneous death clause imputing John as the first to die and Jane as
survivor would.15
Example: John has $8 million in assets, Jane $2.5 million. There is no
community property. John believes the popular press and thinks he can
rely on portability and the DSUEA to kick in and shelter their $10.5
million. But, John and Jane are in a tragic accident together. Neither
John nor Jane has a surviving spouse. John’s estate cannot elect to use
$2.75 million of Jane’s wasted Basic Exclusion Amount and now their
family needlessly pays a tax on John’s estate of $1,100,000 ($2.75 million
excess times 40%).
Thinking Outside the “Outright Bequest v. Bypass Trust” Box
Of course, simple outright gifts and traditional bypass trust planning are not the
only two options – and they need not be “all or nothing”. Disclaimer funded
bypass trusts allow the surviving spouse to choose how much is allocated
between those two options. The chief disadvantage of disclaimer planning is
that it prohibits the surviving spouse from using powers of appointment for
greater flexibility and requires timely and proactive analysis and action (and,
just as importantly, restraint) immediately after the death of a loved one. As
discussed further herein, this loss in flexibility may cost the family dearly.
Attorneys may wish to consider a savings clause/funding variant similar to the
Clayton QTIP16 to save the use of the exclusion via bypass trust even if the
Form 706 filing to claim portability is botched.17 The Clayton QTIP/bypass
trust combination may also save additional basis if the surviving spouse dies
within 15 months.
Example: John dies leaving $1.25 million IRA outright and $4 million in
non-IRA assets to his wife Jane in trust. To the extent a QTIP election is
not made, the $4 million will go into a flexible bypass trust. If the QTIP
election is made, the $4 million will go into a QTIP trust for Jane. Jane
dies a year later with $5 million of her own assets (including the rollover
IRA), and John’s trust has since appreciated to $5 million. John’s estate
makes the QTIP election and elects to port all $5.25 million DSEU, Jane’s
estate includes her $5 million, plus the $5 million QTIP, and the entire
estate receives a new basis (absent IRD/IRA). Conversely, John’s
executor would not make the QTIP election had the market dipped and
John’s trust depreciated to $3 million, to save from a “step down” in
basis.
Extreme, but not uncommon, scenarios such as this could save hundreds of
thousands of dollars in basis by building flexibility into the plan. Even a heavy
bond portfolio (approximately 10 yr duration) could easily decrease in value
25% if interest rates went up a couple percentage points.18 Practitioners may
want to file for a six month extension on Form 706 even if no estate tax would
be due to buy additional time, unless one of the preferred Optimal Basis Increase
Trust design options, discussed in Part III, is utilized.
Part II - Using Marital Deduction Trusts and Other Options to Avoid Basis
Stagnation
We should consider at least two well known alternatives that get us closer to
preserving the best basis increase for the family. First, let’s consider the use of
marital deduction trusts. This may strike some people as a very odd concept –
why would someone use a marital deduction trust if there is no need for the
federal marital deduction? Two reasons – the first is to exploit state estate tax
savings, especially since most of these states allow a different state QTIP
election.
Secondly, these are simple vehicles that get a second step up in basis without
sacrificing the asset protection and control of a trust. Succeeding
trusts/beneficiaries generally receive a new basis when assets are in the decedent
beneficiary’s estate in a general power of appointment (GPOA) marital trust or a
qualified terminal interest property (QTIP) marital trust.19
The QTIP marital trust can be more restrictive at second death than a GPOA
marital trust, by restricting or even eliminating the surviving spouse’s power to
appoint.20 However, especially in smaller estates of couples with children of the
same marriage, and states with no state estate tax or a high exemption, the
GPOA marital trust should see a rise in popularity because of the absence of
any need to file a Form 706 to get the second step up in basis, the better
compatibility with disclaimer planning and the reduced risk of valuation
discounts hampering basis increase.
Example: John and Jane, married, in their mid 70s, have less than $1
million each. They wish to leave assets in trust to each other for all the
various non-tax reasons herein, but want to preserve the second step up in
basis at the second death. Using a QTIP design requires the first
decedent’s executor to file a costly Form 706 with the appropriate QTIP
election - otherwise, it’s no different than a bypass trust, and won’t get a
step up in basis at the second spouse’s death. However, using a GPOA
marital trust does not require such a filing. Even if no Form 706 is filed at
the first death, assets in the GPOA marital get a new adjusted basis at the
second death.21 Furthermore, their attorney knows that John and Jane
probably won’t completely fund their trust and may need to disclaim
some assets to fund the trust. A QTIP trust with a standard limited power
of appointment (“LPOA”) requires disclaiming the LPOA as well,
whereas a testamentary GPOA can be retained by a spouse without
tainting a qualified disclaimer.22 Using various techniques discussed
further below, John and Jane also curtail the threat of the GPOA
potentially altering their estate plans, so the GPOA marital will probably
be the better design for their trust.
Moreover, GPOA trusts may also be preferred for taxpayers in the 99% who
would fund a portion of real estate or fractional interests in LLCs/LP/S Corps,
for example, into trust.
Example: John and Jane, in the example above, plan to fund their trust
with their 50% interest in a home valued at $600,000 and 50% of rental
property LLC, underlying asset value $500,000. If a QTIP is used, the
surviving spouse’s estate must value the ½ in QTIP and the ½ in the
surviving spouse’s estate separately, generating a fractional interest,
and/or marketability, non-controlling interest “discount”.23 At second
death, these values might total $500,000 and $300,000 respectively rather
than $600,000 and $500,000. This reduction in valuation would be
optimal planning if Jane had a taxable estate, but for most people,
“discounting” will save no estate tax and cost the heirs significant basis
increase – for Jane and John’s family, $300,000. Had the 50% interest in
the home and 50% LLC interest gone to a GPOA marital trust for the
survivor, the two halves would be valued together for estate tax at the
second death, and therefore retain full FMV of basis.24
GPOA trusts may also be preferred for taxpayers in states such as New York and
New Jersey that do not permit a separate state QTIP election.25 Another reason
marital GPOA trusts might be preferred for taxpayers with estates under the
applicable exclusion amount is potential threat posed by IRS Rev. Proc. 200138. Rev. Proc. 2001-38 outlines a procedure to permit taxpayers and the IRS to
disregard a QTIP election, even though the election is irrevocable, under certain
circumstances. It was clearly designed to help taxpayers who unnecessarily
over-qtipped what should have remained a bypass trust. There is no indication
that the IRS will use it as a weapon of attack, against a taxpayer’s interests, yet it
does purportedly allow them to “disregard the [QTIP] election and treat it as null
and void for purposes of sections 2044(a), 2056(b)(7), 2519(a) and 2652.”26
Since the basis rules under IRC §1014(b)(10) reference inclusion via IRC
§2044, this would be a problem in preserving a second basis increase, because
denying the QTIP election would deny inclusion under IRC §2044, and hence
deny the new basis. There are persuasive arguments that this Rev. Proc. should
not entitle the IRS to retroactively disregard a validly made QTIP election on
their own accord. However, until the IRS issues further guidance some
practitioners may prefer to avoid the issue altogether and use a GPOA for their
marital trust (or use intervivos QTIPs, to which the Rev. Proc. does not apply, if
your state has fixed other intervivos QTIP problems).27 This will depend on
whether a GST/reverse QTIP election would be used, the compatibility of the
estate plan with powers of appointment and other factors. QTIPs will probably
remain the preferred vehicle for potentially estate taxable estates.
Thus, marital trust planning can combine the income tax basis benefit of the
outright/portability option with the estate preservation and the asset protection
planning advantages of a bypass trust. Marital trusts can solve the first major
drawback of the bypass trust discussed above - basis, and can solve most of the
twelve drawbacks of outright planning discussed above.
But we might do even better. After all, marital trusts typically don’t solve the
higher ongoing income tax issue, and are problematic in that they also receive a
second step down in basis. Moreover, they cannot spray income as a bypass
trust could and they are leaky for both asset protection and tax reasons, because
of the mandatory income requirement. They provide greater complications for
see-through trust status (aka “stretch IRAs”), especially for GPOA marital trusts.
They cannot use broad lifetime limited powers of appointment. They cannot be
used by non-traditional couples who are not officially recognized as “married.”
Furthermore, they simply won’t be as efficient in saving state estate taxes or
federal estate taxes, especially if the surviving spouse does live long and assets
appreciate significantly, since the DSUEA amount is not indexed for inflation.
What ways other than using marital deduction trusts could we achieve a
second step up in basis at the surviving spouse’s death on assets in a bypass
trust?
We could build greater flexibility to accomplish the same goals by either:
1) giving an independent trustee (or co-trustee, or “distribution trustee”)
discretion to distribute up to the entire amount in the bypass trust to the
surviving spouse;
2) giving an independent trustee or trust protector the power to add or create
general testamentary powers of appointment, or effecting the same via decanting
or other reformation under state law;
3) giving another party or parties (typically a child, but it could be a friend of
spouse or non-beneficiary)28, a non-fiduciary limited lifetime power to appoint
to the surviving spouse;
4) giving the surviving spouse a limited power to appoint, but enabling both the
appointment and the appointive trust to trigger the Delaware Tax Trap over the
appointed assets;29
5) giving the surviving spouse a limited power to appoint that alternatively
cascades to a general power to the extent not exercised.30
6) giving the surviving spouse a general power to appoint appreciated assets up
to the surviving spouse’s remaining applicable exclusion amount.
This commentary will focus on the advantages of the last three of these, referred
to as an Optimal Basis Increase Trust. The problem with the first two above
techniques, which involve placing the burden on the trustee or trust protector, is
that they are often impractical and require an extraordinary amount of
proactivity and omniscience, not to mention potential liability (for actions and
inactions) for the trustee or trust protector.
Gallingly, clients don’t tell us when they are going to die, hand us accurate cost
basis and valuation statements, marshal beneficiary agreement and give us
enough time to amend, decant or go to court to change the estate plan to
maximize tax savings. Furthermore, fiduciaries taking such drastic steps are
likely to wish to hire counsel, get signed waivers, or consult a distribution
committee – time for which may be scarce in a situation where the surviving
spouse is hospitalized or terminally ill.
Distributing assets outright to the surviving spouse, even if clearly under the
authority of the trustee, protector or donee of a power of appointment, risks
losing the asset protection for the family and risks a disinheritance or removal
outside in the family bloodline. Plus, we’ve all heard cases of someone on
death’s door that miraculously makes a full recovery and lives another decade or
more. Once the assets are out of trust, you can’t simply put them back in and
have the same tax results.
Adding a general testamentary power of appointment does not have quite the
same level of risk, nor the same destruction of asset protection from outside
creditors, as an outright distribution.31 However, even if permitted by the
document, by decanting statute and/or approved by a court, such a technique
risks retroactively disqualifying an earlier-made qualified disclaimer as well as
disqualifying a “see-through” trust if IRA or other retirement benefits are (or
were?) payable to the trust. This may be true even if the trust qualified at the
time, and even if the power remains unused.32
The third technique, using a limited lifetime power of appointment, avoids some
of these drawbacks, but breeds others. We have all seen cases where a spouse
remarries, and perhaps one child would happily distribute 100% to mom or dad
whenever they asked, but the other children would be livid (and potentially
disinherited indirectly by their sibling). There is no reason that such a lifetime
limited power to appoint could not be made conditional upon unanimous
consent of the children, but this of course brings up the possibility of one child’s
obstinance holding back the family’s tax planning.
So, how do we better ensure that assets get a step up, not a step down, don’t
cause extra state estate tax (or federal), and get better ongoing income tax
treatment and asset protection than a typical bypass or marital trust, without the
above drawbacks?
We’ll now turn to the 4th, 5th and 6th methods above, which use formula powers
of appointment to allow for firmer and more precise tax planning. I will refer to
all of these variants together as an Optimal Basis Increase Trust (OBIT).
Part III - The Optimal Basis Increase Trust (OBIT)
Using testamentary general and limited powers of appointment (“GPOAs” and
“LPOAs”) more creatively can assure that assets in the trust receive a step up in
basis, but not a step DOWN in basis, and these can be dynamically defined or
invoked so as to not cause additional state estate tax.
Example: John Doe dies in 2013 with $2Million in assets left in trust for his
wife Jane. She files a Form 706 and “ports” $3.25 million DSUE. We’ll
assume that most of this gain has been realized, though with more tax efficient
or buy/hold strategy, realization may be less. After 8 years, when she dies, these
trust assets have grown to $4 million, as follows:
Traditional deductible IRA33
basis $0,
FMV $700,000
Total “IRD” Property
basis $0
FMV $700,000
Apple Stock (the iPhone 10 flopped),
basis $500,000, FMV $200,000
Condo in Florida (hurricane depresses value),
basis $1,000,000, FMV $600,000
LT Bond portfolio (inflation depressed value)
basis $400,000 FMV $300,000
Various stocks that have decreased in value
basis $150,000, FMV $100,000
Total “loss” property
basis $2,050,000,FMV $1,200,000
Rental Real Estate34
basis $200,000, FMV $600,000
Various stocks that have increased in value
basis $400,000, FMV $900,000
ST Bond Portfolio, Money market
basis $400,000, FMV $400,000
Gold
basis $100,000 FMV $200,000
Total “gain” property
basis $1,100,000,FMV $2,100,000
Total at Jane’s death
basis $3,150,000 FMV $4,000,000
Had John used an outright bequest, or a marital trust, all of the assets above
(except the IRA) would get a new cost basis – including the loss properties.35
Had John used an ordinary bypass trust, none of the assets above would get a
new cost basis, including $1 million of unrealized gains (see chart below)!
Instead, John’s Optimal Basis Increase Trust (OBIT) grants Jane a limited power
of appointment (or no power at all) over all IRD assets and assets with a basis
higher than the fair market value at the time of her death (total assets $1.9
million). It grants Jane a general power of appointment over any assets that
have a fair market value greater than tax basis (total assets $2.1 million). As
discussed below, this may also be accomplished with a limited power of
appointment that triggers the Delaware Tax Trap.
John Doe Trust
Traditional AB Trust
John Doe Trust
John Doe Trust
Fbo Spouse (& poss.
children)
Fbo spouse only QTIP,
< $5.25mm (or basic excl)
> $5.25mm (or basic excl)
Trust for children
Trust for children
No change in basis
All new basis
John Doe Trust
Optimal Basis
Increase Trust
John Doe OBIT
John Doe Marital Trust
Fbo Spouse (& children?)
Fbo spouse only,
< $5.25mm (or basic
exclusion amount)
> $5.25mm (or basic
exclusion amount)
Trust for child(ren)
Trust for children
Step up in basis for assets
w/basis < FMV
No change in basis (IRD,
assets w/
(up to spouse’s AEA)
Basis > FMV)
Trust for children
All new basis
(including step down)
New Basis at Surviving Spouse’s Death if using: Ordinary Bypass QTIP/outright
Traditional deductible IRA
OBIT
$0
$0
$0
$500,000
$200,000
$500,000
Condo in Florida (hurricane depresses value)
$1,000,000
$600,000
$1,000,000
LT Bond portfolio (inflation depressed value)
$400,000
$300,000
$400,000
Various stocks that have decreased in value
$150,000
$100,000
$150,000
Rental Real Estate
$200,000
$600,000
$600,000
Various stocks that have increased in value
$400,000
$900,000
$900,000
ST Bond Portfolio, Money market
$400,000
$400,000
$400,000
Gold
$100,000
$200,000
$200,000
$3,150,000
$3,300,000
Apple Stock (the iPhone 9 flopped),
Total Basis for Beneficiaries at Jane’s death
$4,150,000
Result: John and Jane Doe’s beneficiaries get a step up on the trust assets, but,
more uniquely, do not get a “step down” in basis for any loss property (in our
example, new basis is $4,150,000 versus $3,150,000 had a standard bypass trust
been used and only $3,300,000 of basis had a marital trust been used. That’s a
lot of savings. The beneficiaries (through a continuing trust or outright) get a
carry over basis over any assets received via limited power of appointment (or
received by default if such assets were not subject to a general power of
appointment at death). This allows them to use the higher basis for depreciable
assets to offset income, or sell assets to take the capital loss to offset other
capital gains plus $3,000/yr against ordinary income, or hold for future tax-free
appreciation up to basis.
Think people won’t die with unrealized capital losses? It happens all the time.
Ask anyone who handled an estate in 2008-2009. It is a dangerous misnomer to
call the basis adjustment at death a “step up” without realizing it’s equally a
“step down” when assets don’t appreciate as we had wished them to, yet we are
all guilty of this pollyannaish shorthand. Increasing trust capital gains tax rates,
discussed in more detail in Part V, may cause more tax sensitivity in trustees,
meaning more use of individually managed bonds and equities or at least lowturnover funds or ETFs in order to decrease turnover and gains realization,
which would in turn mean even more unrealized gains in future spousal trusts.
Why haven’t people done this before? Besides the frustrating instability of the
transfer tax regime and the smaller exemptions prior to EGTRRA, there are two
main reasons: if not properly curtailed with careful drafting, it could increase
estate tax exposure and decrease testamentary control by the first spouse to die.
Solutions for these two issues will be discussed below. Regarding the first
reason, we need to wake up and smell the new paradigm. What percentage of
the population cares about the estate tax now, even with some assets included in
both estates?
Let’s revisit our example above. Let’s say Jane has $3 million of her own
assets. Her DSUE from her late husband John was $3.25 million (frozen, not
adjusted for inflation), and her own basic exclusion amount is $6.25 million
($5.25 million plus 8 years of estimated inflation adjustments adding $1 million
more). Even if she had missed the Form 706/portability filing, adding $2.1
million to her estate doesn’t even come close to her $9.5 million applicable
exclusion amount. But what if Jane wins the lottery and has $9 million in her
estate without John’s trust? Could this type of trust provision cause $640,000 of
additional estate tax ($9 million plus $2.1 million, minus $9.5 million AEA,
times 40% rate)?
Fortunately, John’s Optimal Basis Increase Trust includes a formula. The
GPOA is only applicable to those assets to the extent it does not cause increased
federal estate tax (and takes into account state estate tax, discussed further
below). Powers of appointment can be limited in scope as to either appointees
or assets. Many existing trusts already have GPOAs over only a portion of the
trust (typically, the GST non-exempt share). There is no reason one cannot
grant a general power of appointment over less than 100% of trust assets, or by
formula.36 All of our traditional planning has A/B/C, GST formulas that the IRS
has blessed and this is no different.
Furthermore, the appointment could be applicable to the assets with the greatest
embedded gain to satisfy this amount. The drafting difficulty is not so much in
capping the GPOA but in creating the ordering formula and adjusting for
individual state estate taxes.
Let’s take the non state-taxed situation first. In our scenario above, Jane’s estate
has only $500,000 of applicable exclusion to spare, but the appreciated
“stepupable” assets of the OBIT total $2.1 million. Which assets should be
stepped up first?
Assets that may incur higher tax rates, such as collectibles (artwork, antiques, or
gold, in the example above) would be natural candidates for preference. On the
opposite end of the spectrum, other assets might have lower tax rates or
exclusions, such as qualifying small business stock or a residence that a
beneficiary might move into, but those would be relatively rare situations. Most
families would prefer the basis go to depreciable property, which can offset
current income, before allocating to stocks, bonds, raw land, family vacation
home, etc. Therefore, ultimately a weighting may be optimal, but at the most
basic level practitioners would want the GPOA to apply to the most appreciated
assets first.
Some of this analysis will sound similar to those who handled estates of those
who died in 2010 when the price to pay for no estate tax was a limited step up in
basis. While the concept sounds similar, in practice, it is quite different. In
2010 the executor could choose assets to apply a set quantity of basis to,
pursuant to specific statute.37 Ideally, we would like to give Jane’s executor or
the trustee the power to choose the assets to comprise the $500,000 of appointed
assets – in both drafting and in practice that is deceptively simple. However,
this is quite different from 2010 carry over/step up law, and different from “pick
and choose” formula funding.
If the power of appointment is deemed to apply to a pecuniary amount (here,
$500,000), rather than a fractional formula (500,000/2,100,000), it may have
undesired income tax consequences.38 Thus, we should avoid simple powers of
appointment over, for example, “an amount of assets equal to my spouse’s
remaining applicable exclusion amount”.
If Jane’s testamentary power potentially extends to all of the applicable property
equally ($2.1 million), only limited to $500,000, all property subject to that
provision should get a fractional adjustment to basis accordingly – no different
than if a child dies at age 36 and had a power to withdraw 1/3 of corpus at age
35 and did not take it – all assets would get a 1/3 basis adjustment.39 A pro rata
adjustment would lead to wasted basis, since a $1,000,000 asset with $1 gain
would soak up the same applicable exclusion amount as a $1,000,000 asset with
$900,000 gain. This would be better than no extra basis at all, but not as optimal
as the trustee limiting the powerholder’s general power, or, more conservatively,
establishing an ordering rule.
The trustee might be given a fiduciary limited power of appointment to choose
the appointive assets subject to the beneficiary’s general power of appointment.
Black letter law defines a power of appointment as “a power that enables the
donee of the power to designate recipients of beneficial ownership interests in or
powers of appointment over the appointive property.”40
Arguably, a trustee with such a power would be the donee of a fiduciary limited
power of appointment to designate recipients of powers of appointment over the
appointive property.41 Assuming the trustee is independent, this could arguably
limit the spouse/donee’s GPOA over only specific assets chosen by the trustee.
However, it is probably more conservative and simpler in concept to simply
make clear the GPOA never applies to the less appreciated assets, and is never
subject to any powerholder’s discretionary choice.
So, in our example, the trust provides that GPOA applies to the most appreciated
asset first, cascading to each next individual asset until $500,000 in total
property is reached. In our case, the real estate has the greatest appreciation
(assuming there is not a more appreciated stock in “various stocks” category),
thus the GPOA would apply to 5/6 interest (be it % as tenant in common, or
more likely, % LLC membership interest). Thus, the basis would be increased
to FMV on the date of Jane’s death as to 5/6 of the property (5/6 times
$600,000, or $500,000) and the remaining 1/6 would retain its carry over basis
(1/6 of $200,000, or $33,333).42 This means a basis increase from $200,000 to
$533,333. This method could easily make for a rather extensive spreadsheet
when dealing with many dozens of individual stock positions. But, this is no
different from what executors and their accountants had to build in 2010.
In our ordering example, the GPOA could never apply to the less-appreciated
assets, and hence the IRS would have no statutory basis to include them in
Jane’s estate (or accord them an adjusted basis). It applies to specific property,
not a dollar amount or a fraction (though it could apply to say, 34 of 100 shares,
etc). If the most appreciated property is family business stock, that’s what it
applies to, and there is no discretion in the trustee or the powerholder to change
the appointive assets subject to the GPOA. While this gives up a small amount
of flexibility over the trustee power noted above, it is probably the more
conservative route.
If the spouse is the sole trustee or sole investment advisor under direction or
delegation, could his or her indirect power to affect gains and losses on
investments, and therefore basis, somehow deem such powers to be general over
all the assets up to the remaining applicable exclusion amount? This would be
quite a stretch, since the Uniform Prudent Investor Act and other fiduciary
duties preclude any self-dealing or avoidance of diversification unless the
document waives those duties. Still, this may simply be one more reason for a
conservative practitioner to use an independent trustee, co-trustee and/or
investment trustee.43
If such a design is undesirable, it may be good reason to rely instead on granting
the spouse a limited testamentary power of appointment eligible to trigger the
DTT, which could be over all assets equally. Any structuring to exploit a step
up or avoid a step down would be done through the spouse’s own Will or Trust
exercising the non-fiduciary LPOA, rather than through the trust document or
vagaries of investment return, and therefore immune to any such argument.
Variations to Accommodate Separate State Estate and Inheritance Taxes
We do not want inclusion in the federal estate, even if it causes no estate tax, to
also inadvertently increase state estate tax, unless there is a greater overall
income tax benefit.44 Consider the extremes: we may not want to grant a GPOA
over stock bought at $95 rising to $100 at date of powerholder’s death, because
the $1 or so in potential capital gains tax savings does not justify inclusion if the
state estate tax incurred is $12-16! Clients in those states may have a $1 of $2
million state estate tax exempt trust and up to $3.25 or $4.25 million stateQTIPed trust. Obviously the latter is first choice to cull any basis from by
inclusion in the beneficiary’s estate.
Conversely, assets with a lot of gain may benefit from an increase despite some
state estate tax. With the exception of Washington, most states that have estate
tax also have a substantial state income tax, so that savings should be considered
as well. The gold in the example above might be said to benefit from $40,000 of
so of tax savings by increased basis ($100,000 gain time 31.8% federal, 8.2%
net state income tax if assets sold), as opposed to perhaps $24,000 or so in state
estate tax loss ($200,000 inclusion times 12% rate). Again, this can be
accomplished with a formula to ensure that increases to the estate are only made
to the extent that the value of the step up exceeds the cost of the extra state
estate tax. Out of state real estate or assets with special state credits, exclusions
or special valuations should also be considered.
Practitioners in states with a $1 million estate tax exemption may opt for
simplicity of drafting/administration and simply forego the GPOA over any
state-estate tax exempt trust property, since the savings would not be as great.
However, surviving spouses may change residence or the state tax regime may
change (as it has recently in Ohio, Indiana and other states). Some states have
larger exemptions of $2 million, $3.5 million or more that make it more
compelling. Practitioners may want to modify their formula with something
similar to soak up available state estate tax exclusion, and then limit appointive
assets above the amount of available state estate tax exclusion.
Thresholds can be created to the extent state estate tax is triggered. For
example, only “collectible assets with basis 70% or lower than fair market value
at date of death, real estate with basis 60% or lower, or any other asset with a
basis 50% or lower.” The above percentages are approximations and clients and
practitioners may deviate from these considerably, but the concept is to create
some greater threshold for inclusion if state estate tax were to be paid. Some
clients may prefer to forego a basis increase at second death altogether if a 1219% state estate or inheritance tax were incurred, on the theory that any capital
gains tax can theoretically remain unrealized until the beneficiary’s death and
receive an additional step up. Depreciable assets may be preferred as appointive
assets due to the ability of additional basis to decrease a beneficiary’s current
taxation.
Crafting GPOAs to Keep Fidelity to the Estate Plan and Preserve Asset
Protection
This brings us to the second perceived drawback of such planning – the potential
thwarting of an estate plan by the inclusion of a testamentary general power of
appointment. Remember that the IRS has historically bent over backwards to
construe a GPOA, because in the past it produced more revenue than a more
restrictive interpretation. Thankfully, we have a broad statute, regulations and
many tax cases on which to rely, as well as favorable law in the asset protection
context, so that GPOAs may pose little threat to the estate plan if properly
constructed.
If the GPOA marital deduction is claimed, any GPOA must include the spouse
or spouse’s estate, not just creditors, and must be “exercisable by such spouse
alone and in all events”.45 However, if no marital deduction was claimed, as we
aim to do in an Optimal Basis Increase Trust, the following limitations may be
included:
A GPOA may limit the scope of eligible beneficiaries so long as creditors
of the powerholder are included. For example: “I grant my beneficiary
the testamentary power to appoint to any of my descendants [or to any
trust primarily therefore, which is usually an option for trusts not designed
to qualify as a “see through accumulation trust” for retirement benefits].
My beneficiary also may appoint to creditors of his or her estate.”46
Furthermore, a power is still a GPOA if it may only be exercised with the
consent of a non-adverse party.47 Surprisingly, even a trustee with fiduciary
duties to other beneficiaries is not considered adverse.48 For example, one might
add to the above: “However, my beneficiary may only exercise said appointment
with the consent of [name of non-adverse party, or] my trustee, who must be a
non-adverse party.” If you name a trustee, then you would then want provisions
to enable appointment of a non-adverse party as trustee if, for instance, a
beneficiary were the successor trustee (and adverse) and the beneficiary actually
attempted to appoint to their creditors. If you name a non-adverse party, make
sure to name alternates in the event the first is deceased or incapacitated. In
theory, one could name multiple non-adverse parties necessary for unanimous
consent, but that pushing the envelope is hardly necessary.
Furthermore, a GPOA is “considered to exist on the date of a decedent's death
even though the exercise of the power is subject to the precedent giving of
notice, or even though the exercise of the power takes effect only on the
expiration of a stated period after its exercise, whether or not on or before the
decedent's death notice has been given or the power has been exercised.”49 This
offers even more opportunity to make GPOAs more difficult to actually
exercise, yet still come within the safe harbor of a treasury regulation.
If there is a qualified plan or IRA payable to the trust designed to be a see
through trust (specifically, an “accumulation” trust, it would not be necessary
for a “conduit” trust), one might consider a further restriction to prevent
disqualification – “to creditors who are individual persons younger than
[intended designated beneficiary]”. This is a technique seemingly blessed by a
recent PLR that permitted such a circumscribed GPOA to retain see through
trust status.50 Although the OBIT techniques herein to increase basis would not
apply to IRAs or qualified plans,51 you may yet have a GST non-exempt share
over which a GPOA is desired. It would probably be preferred to use a conduit
trust or trusteed IRA instead, but if for some reason that is undesirable, there
may not be a lot to lose in circumscribing the GPOA in this manner as applied to
such a trust.
Generally, I would not attempt to limit a GPOA in this manner for any nonstandalone IRA accumulation trust – requiring appropriate non-adverse parties’
consent should be more than adequate to prevent unwanted exercise. That said,
it may still be prudent to limit the power to appoint to creditors to the amount of
the debt owed and to reasonably equivalent value for contractual debt.52
While a handful of states have creditor-friendly state law impacting testamentary
GPOAs, the law is generally favorable as to whether and when a testamentary
general power of appointment subjects the appointive assets to the donee
powerholder’s creditors, although in bankruptcy the assets are not subject to
creditors.53 It may depend on whether the power is exercised or whether it is
merely allowed to lapse. Creditor access should be less likely if there are
additional consent and notice requirements as discussed above, but again this
depends on state law and there are apparently no cases discussing asset
protection differences of GPOAs with the various proscriptions described above.
This is in stark contrast to the exposure of a presently exercisable general power,
which will be discussed further below.
Using the Delaware Tax Trap Instead of a GPOA to Optimize Basis
In our examples of John and Jane Doe above, we presumed that the Optimal
Basis Increase Trust used a formula GPOA to cause estate inclusion and
increased basis. However, there is also a technique to accomplish the same
result with a limited power of appointment. This involves IRC §2041(a)(3),
colloquially known as the Delaware Tax Trap (“DTT”).54 The application of
this rule, in conjunction with the rule against perpetuities, is complex. I will
refer the reader to more learned articles on the subject, but will only hit the
highlights of the practical import of this for purposes of this article.55
Generally, if Jane in our example had a limited power of appointment which
permitted appointment in further trust, and Jane appointed those assets to a
separate trust which gives a beneficiary a presently exercisable general power of
appointment, this would trigger §2041(a)(3), cause estate inclusion, and
therefore an increased basis under IRC §1014, just as a standard GPOA would.56
Thus, Jane’s Will (or trust or other document, if permitted by John’s trust)
would appoint any appreciated assets to such a “Delaware Tax Trapping” trust
as discussed above. In drafting mode, this is probably not an optimal strategy to
employ for John’s trust, because it will necessarily require Jane to draft a new
Will invoking the LPOA and a new appointive trust with terms that one would
ordinarily avoid. Giving a beneficiary a presently exercisable GPOA impairs
asset protection much more than a testamentary power, and destroys any chance
of spraying income or making tax-free gifts, nor does it allow avoidance of state
or federal estate taxation or avoidance of a step down in basis at the child’s
death.57
With all of the above negatives, using the DTT to harvest the basis coupon
probably has more realistic application in the context of preexisting irrevocable
trusts that already contain an LPOA, as discussed in Part IV, and should
probably not be used in planning mode to accomplish optimal basis adjustments,
especially since many practitioners and clients rely on disclaimer funding, which
kills the LPOA necessary for a DTT (recall that the formula GPOA does not
preclude qualified spousal disclaimers, as previously discussed). However, if
the trust for children pays outright anyway, and no disclaimer funding is
anticipated, this route may be the easiest to take.
Practitioners could even craft a “Crummey” like provision into the appointive
trust so that the presently exercisable GPOA lapses into a self-settled,
incomplete gift domestic asset protection trust with situs in Ohio, Delaware,
Alaska or other permitted state after 30 days.
Optimizing Basis Increase at First Death
Married couples living in community property states automatically receive a
new date of death basis for community property (which can, of course, mean a
step down in basis for property as well).58 This might exclude significant
property that might be separate – such as assets gifted or inherited property or
assets earned prior to marriage. Increasing step up in basis at first death for such
separate property (and avoiding double step downs for community property that
has tanked in value) may be accomplished through postnuptial transmutation
agreements.
Those living in separate property states may be able to accomplish the same
result through the use of an Alaska Community Property Trust, keeping “loss”
or qualified plan property out of the trust and transferring gain property to the
trust to count as community property.59 While there is a compelling argument
that those should work equally well, to date this technique has not been tested in
the courts or subject to any IRS ruling.
Example: John and Jane are on their second marriage and therefore have
significant separate property. In a community property state, John and Jane
might each agree that $1 million of their low basis property is community
property. In a non-community property state, they might put those assets into an
Alaska Community Property Trust. Of course, if John’s former separate
property value skyrockets to $2 million, and Jane’s stays the same at $1 million,
and they are later divorced, this $3 million is 50/50 for divorce purposes. But
many clients could live with this, when considering that if one dies, all $3
million gets a new adjusted basis – a substantial windfall for the widow/widower
and potentially others.
The so-called “joint GPOA” (aka poorer spouse funding technique) trust
proposed by some to use in separate property states could be a disaster, because
IRC §1014(e) would probably require a step down, but deny a step up.60 The
IRS would consider this property transferred by gift and returned to the donor
(or trust therefore) within one year. There may be colorable arguments that it
should still be eligible for a basis increase, but you have at least four PLRs to the
contrary and an uphill battle to argue for it.
Increased Asset Protection Opportunities and Basis Plays Due to the
Larger Exclusion Using Lifetime Trusts (the “poor man’s DAPT”?)
The increased exclusion also offers up greater asset protection planning
opportunities. Consider this variant for smaller estates: Husband sets up an
irrevocable trust (aka SLAT) for Wife (defined as whomever he is married to at
the time, since we do not need to qualify for the marital deduction as an
intervivos QTIP or GPOA). Wife has a testamentary GPOA, circumscribed as
discussed above. Wife and/or children have a lifetime limited power of
appointment to appoint to Husband/Father. Merely being a permissive
appointee of a limited power of appointment should not threaten asset
protection, even if the donor of the power is a permissive appointee. If wife dies
first, and the GPOA is not exercised, or if it is exercised successfully in favor of
the husband, husband becomes beneficiary of the trust. Unlike intervivos QTIPs
or LPOA exercises that “relate back” (thus making it self-settled as to Husband),
the settlor changes at Wife’s death pursuant to a GPOA (though with a lapse of
the GPOA, it may only change as to 95%).61 This means that the trust is not
self-settled if Husband later becomes beneficiary. OBIT techniques can be used
here as well to avoid any step downs in basis at wife’s death, or limit inclusion
should she have a taxable estate.
In some states, you can achieve very close to DAPT protection with an
intervivos QTIP as well, so that less gift/estate tax exclusion is used for clients
of larger estates.62 In other states, an intervivos GPOA marital may be preferred
to achieve the same tax and asset protection result.
Furthermore, you have flexibility regarding grantor trust status for income tax
purposes after W’s death. If W exercises her testamentary general power of
appointment, she would be considered the grantor after her death. However, if
she merely lets her GPOA lapse, she would not be- a result that the family may
prefer.63 This is yet another area where state law, estate tax and income tax law
do not necessarily stride in lock step.
Unlike DAPTs, which have to be done in certain states, use certain trustees, and
have various uncertainties, requirements and drawbacks, such trusts can be done
in any state. However, some states may wish to reinforce the common law, as
Ohio has recently done, that merely being a permissive appointee under a
lifetime power of appointment does not make a trust “self-settled”.64
Part IV - Use of Optimal Basis Increase Techniques by Pre-Existing
Irrevocable Trusts
The concepts herein can also be applied to inter-vivos irrevocable trusts and
trusts continuing for additional generations. Similar techniques can be
incorporated in downstream dynastic trusts for better basis increases to
grandchildren and beyond. This would involve GST considerations as well.
Most importantly, practitioners should not overlook the significant value in
adapting many pre-existing irrevocable bypass trusts (including intervivos
SLATs) to fully use this $5.25 million (and increasing) basis increasing
“coupon”. This may be done by various ways – triggering the Delaware Tax
Trap using an existing limited power of appointment that permits appointment to
trusts, or changing the trust via decanting, private settlement agreement or court
reformation to add a limited or general power of appointment. Choice of these
options will be somewhat state law dependent.
The advantages may be significant. Imagine how many current irrevocable
bypass trust surviving spouse beneficiaries have well under $5.25 million in
their personal estate? (or more, if their spouse died after 2010 and they elected
DSUEA).
Example: John died in 2008, leaving his wife Jane $2 million in non-IRA
assets in a typical bypass trust, which has now grown to $3.5 million.
Although some of the assets have been sold, rebalanced, the trust assets
now have a basis of $2.5 million. Jane’s assets are $2.5 million. Why
waste $2.75 million of her $5.25 million “coupon” she is permitted to use
to increase basis step up for her family? Jane therefore amends her
will/trust to exercise her limited power of appointment granted in John’s
trust, mirroring language discussed above: assets with basis greater than
FMV or IRD go to a trust for her children (or simply continue in trust
under the residuary), and assets with basis under FMV (for which Jane
and her family desire the step up) simply go to a similar trust for her
children that contains a presently exercisable general power of
appointment, triggering IRC §2041(a)(3) and getting the family up to an
additional $1 million of basis free of charge. And, of course, this exercise
can be limited to her available Applicable Exclusion Amount and applied
first to the most appreciated assets first, capped to prevent any estate tax
and/or account for any state estate tax as discussed above.
Many beneficiaries do not have current asset protection issues, asset levels close
to a taxable estate or any desire to spray or gift inherited assets. Thus, the vast
majority of LPOA powerholders and their prospective appointees would
probably prefer to save income tax with a higher basis than avoid the negatives
of a presently exercisable GPOA. Unless there are current creditors on the
horizon, beneficiaries can always avail themselves of self-settled asset
protection trust legislation in Ohio, Delaware, Alaska or one of the other
jurisdictions that permit this. So, in practical terms, the main reason to forego
any use of the Delaware Tax Trap is if a powerholder wants to preserve assets
for grandchildren or other beneficiaries.
But let’s say Jane did not have a limited power of appointment, or doesn’t like
the drawbacks of granting the beneficiaries a presently exercisable general
power of appointment. Aren’t we taught after Bosch and similar cases and PLRs
that trying to reform a trust for the marital or charitable deduction post-mortem
(or post gift) should not be recognized?65 Isn’t this a similar trend for see
through trust rulings?66
These cases can easily be distinguished. Most of them concerned taxpayers
trying to change the legal effect of what the trust terms were at the death of the
original transferor (i.e., does it qualify as a marital, charitable or see through
trust at death). They do not concern what a transferee decedent owned or didn’t
own at the time of a transferee’s death.
IRC § 2041 concerns what rights and powers a decedent has over property. If
trust terms change so as to be legally binding, they absolutely change those
property rights. We know of cases and rulings, not to mention every treatise
recommendation on the subject, wherein a beneficiary who becomes their own
trustee without ascertainable standards (or can remove and cause himself or
related/subordinate party to be trustee) should have those assets included in their
estate. A GPOA is no different. The IRS can certainly try to enact a double
standard, but the vast body of 2041 jurisprudence is to the contrary.
In Rev. Rul. 73-142, a grantor/decedent established a trust for his wife and
children, not subject to ascertainable standards, and mistakenly retained the
power to remove and become the trustee.67 Years prior to his death, he went to
court to successfully construe the trust to mean that he could not be appointed
trustee (nowadays, we would also preclude removal and replacement with any
related/subordinate party).68 The IRS ruled that this court order had tax effect to
negate the IRC §2036/2038 issue despite the state court decree being contrary
to the decisions in the state’s highest court. While this is not an IRC §2041
case, this Rev. Rul. bodes well for such proactive planning to add a limited
GPOA for better tax results.
One PLR following Rev. Rul. 73-142 noted a key difference with Bosch:
“Unlike the situation in Bosch, the decree in the ruling [73-142] was handed
down before the time of event giving rise to the tax (that is, the date of the
grantor's death).”69 In that PLR, a state court order construing a tax
apportionment clause to apply to the GST non-exempt marital share rather than
equitably to both GST exempt and GST non-exempt shares was given effect.
This was good proactive planning by counsel prior to the taxing event to keep
more funds in a GST sheltered trust.
Like the above rulings, any such modifications to ensure an Optimal Basis
Increase would similarly affect a surviving spouse’s rights before the time of his
or her death, and with current trust law trends, such reformations would unlikely
even be contrary to the state’s highest court. Obviously, if beneficiaries try to
fashion such a solution after both parents’ deaths, this would be unavailing
under Bosch and many other decisions. However, there is strong precedent that
private settlement agreements, court actions pursuant to statute, decanting, trust
protector or other methods to add a formula GPOA prior to the time of the event
giving rise to the tax (the surviving spouse’s death), should (and must) be given
effect.
The reverse, removing a GPOA, is a more difficult issue, so any reformation
should strongly consider the irrevocable nature of it. Generally, releasing a
general power of appointment would trigger gift tax, and could trigger taxation
of any IRD.70 However, in one recent PLR, the IRS allowed a post-mortem
court reformation to essentially remove a GPOA without adverse tax effect.71 I
would not count on this result for every post-mortem reformation removing a
GPOA, but the PLR is instructive as to how the IRS applies the Supreme
Court’s holding in Bosch.
Recall that any added powers of appointment can be limited to certain trusts as
well. In our example above, if Jane had not been granted a limited power of
appointment, the trustee might decant to a near identical trust which grants Jane
the limited testamentary power to appoint certain assets to the Jane Doe
Irrevocable Delaware Tax Trapping Trust, a trust established with terms nearly
identical to her husband John’s trust for the children, only granting the children
a presently exercisable general power of appointment circumscribed using
techniques discussed above. Indeed, this may be a more prudent exercise of the
trustee’s decanting power (or court’s power to amend), since it would do less
harm to the original settlor’s intentions than adding a broad LPOA or GPOA
(indeed, many trusts pay outright to children at some point anyway).
Part V - The Income Tax Efficiency Trust – Exploiting Ongoing Trust Tax
Techniques
As mentioned above in Part I, there is another tax issue with trusts after ATRA
that may now dissuade the average couple from using ongoing trusts for
planning. With the new tax regime, unless we plan and administer carefully, the
overall income tax to the surviving spouse and family will be higher every year,
sometimes by a considerable amount.
Creative use of IRC §663 and/or IRC §678a loopholes can ensure that capital
gains are not trapped in trust at the highest rates, may get better tax treatment for
special assets, and may even be sprayed to beneficiaries or charities in much
lower (or even 0%) brackets. Non-grantor trusts may have an additional
advantage in some states in their ability to shelter from state income taxation.
CONSIDER: Barbara, recently widowed, is the primary beneficiary of a
$2 million bypass trust established by her late husband. Her income
outside the trust is $70,000. For 2013, the trust has ordinary income of
$40,000 (which I have assumed to be also equal to the trust’s accounting
income and distributable net income (DNI)), short-term capital gains of
$30,000, and long-term capital gains of $70,000. The trustee allocates all
capital gains to trust principal. In its discretion, the trustee distributes to
Barbara all of the accounting income ($40,000) as well as a discretionary
distribution of principal of $75,000 needed for her support. The trust is
entitled to a distribution deduction of only $40,000 and has taxable
income of $100,000 (the sum of its short-term and long-term capital
gains).
The $75,000 principal distribution is not ordinarily included as part of what is
called the “DNI deduction”.72 It is this latter aspect of trust income taxation that
is often overlooked and misunderstood by practitioners, and is potentially the
source and trap for higher tax. Once the trust is over $11,950 of taxable income
(roughly $88,000 in this case), it is taxed at 39.6% (20% if LTCG/dividends),
plus, unless it meets an exception such as IRA/QP distributions, it is also subject
to the 3.8% surtax. See the December 2012 issue of Trusts and Estates,
Avoiding the Medicare Surtax on Trusts, for a more extensive article on these
points.
There are two main ways to counter this. Some family situations, such as
second marriages where a settlor wants the maximum proscription on the
spouse’s distributions and maximum remainder for beneficiaries, do not offer
much in the way of flexibility. We are mostly left with standard income tax
deferral techniques. But for many families, there are good options to avoid this
fate of higher ongoing trust taxation, especially if we are in drafting mode or
have not yet established any history of trust accounting and administration.
There are two main methods – 1) using IRC § 678(a) to allow the spouse to
withdraw all net taxable income, perhaps specifically including all net capital
gains (although “all net income” is common language in trusts, by default this
refers to net accounting income, which typically excludes capital gains and
losses) or, better, 2) coming within one of the exceptions in Treas. Reg.
§1.643(a)-3(b) which allow discretionary distributions to carry out net capital
gains.
If capital gains are considered part of her distribution and ordinary non-grantor
trust rules are applied, the $40,000 of accounting income and the $75,000 of
principal distribution is also taxed to her and only $25,000 is left trapped in
trust. However, because of her extra tax burden, she may ask for more
distributions to compensate, which would probably lower the income trapped in
the trust to well under $11,950. Thus, the 43.4%/23.8% highest marginal trust
tax rate is avoided and her personal rates of 28%/15% would be applicable.
This can lead to tremendous ongoing tax savings.
Furthermore, the settlor may give additional spray powers to the trustee, to spray
income to other beneficiaries, including the family’s favorite charity, donor
advised fund or foundation. As an additional backstop for flexibility, the settlor
may give the surviving spouse a limited lifetime power of appointment.73
For instance, let’s say Barbara receives more income outside the trust, putting
her in a higher bracket, and decides that she only needs $30,000 from the trust,
but her children could use funds to pay for grandchildren in college. She asks
the trustee to consider, and the trustee complies (having instructions to consider
secondary beneficiaries if income is sufficient for the primary), spraying
$80,000 to her children (or grandchildren) and $20,000 to the family’s donor
advised fund at the local community foundation that John had also named in the
trust as a permissible beneficiary.74
Whether this makes sense depends on the family situation, trust and brackets of
the parties involved (and potentially the assets, such as whether an S Corp or
IRA is involved, which might suggest separate trusts). There are many
scenarios where the family would be far better off with this spray capability,
potentially lowering tax rates by 20% or more. Remember, the 0% rate for
taxpayers in the bottom two tax brackets for LTCG/qualified dividends was
permanently extended with ATRA as well.
Notably, not only would IRC §642(c) offer “above the line” charitable
deductions for the family, but it offers a better deal for internationally minded
clients with ties/interests in foreign countries – unlike IRC §170 for individuals,
the trust income tax charitable deduction is expressly not limited to charities
organized in the United States.75
Furthermore, regulations specifically permit that the governing instrument can
provide an ordering rule and control the character of the income distributed via
642(c) provided it “has economic effect independent of income tax
consequences.” For instance, if the trust limits the charities’ potential
distribution to gross income from net short-term capital gains, taxable interest
and rents, it has the economic effect apart from income tax consequences
because the amount that could be paid to the charity each year is dependent upon
the amount of short term capital gains, taxable interest and rents the trust earns
within that taxable year.76 Therefore, in our example, Barbara’s donor advised
fund would not receive any long-term capital gains or qualified dividend or tax
exempt income – the $20,000 would be limited to coming from the interest and
short term capital gains.
This article will not revisit the various pros and cons of the methods enabling net
capital gains to pass out with any distributions to the beneficiary(ies), since it
was covered in last December’s article. Practitioners should familiarize
themselves with Treas. Reg. 1.643(a)-3(b) due to its increased importance under
ATRA.
Pros and Cons of the Optimal Basis Increase and Tax Efficiency Trust
Much of the planning and techniques for the über-wealthy are unchanged after
ATRA – the increased (and increasing) exclusion merely turbocharges previous
gifting techniques. The Optimal Basis Increase techniques herein won’t help a
wealthy couple with $100 million, but they can be extremely valuable for sub$10.5 million estates.
The ongoing trust income tax techniques discussed herein apply to nearly all
estate levels – perhaps even more so to wealthier families. After all, how many
trust beneficiaries, even of wealthy families, will always make over $400,000 or
$450,000 in taxable income and therefore be subject to the same tax rates as a
non-grantor trust?77 Won’t these families typically get the most from charitable
tax deductions in trusts?
For married clients with estates under $10.5 million, the Optimal Basis Increase
and Income Tax Efficiency Trust offers the following advantages over an
outright bequest, even where DSUE is successfully claimed: better asset
protection from creditors, better divorce/remarriage protection, better protection
from mismanagement, better sheltering of appreciation/growth from both federal
and state estate and inheritance taxes, better planning in event of simultaneous
or close death (potentially millions in savings for those estates where one
spouse’s estate is over $5.25 million), better use of GST exclusion, better
incapacity planning, better Medicaid/VA/benefits planning, avoidance of step
down in basis at second death and the ability to spray income to
children/charities in lower brackets. The drawbacks are the same as with any
trust planning: increased attorney fees (and potentially post-mortem,
accounting/trustee fees) and complexity.
The Optimal Basis and Income Tax Efficiency Trust offers the following
advantages over the traditional bypass trust: better step up in basis at second
death, better ongoing income tax treatment for the trust and spouse overall and
better income tax flexibility and charitable deduction treatment via spray
provisions.
The Optimal Basis and Income Tax Efficiency Trust offers the following
advantages over a traditional QTIP: better asset protection during the surviving
spouse’s life (for accounting income), no chance of losing DSEU due to
remarriage, better ongoing income tax treatment for the primary beneficiary,
ability to spray income or capital gains to lower (or 0%) tax bracket
beneficiaries, ability to shelter from state estate/inheritance tax, no requirement
to file Form 706 to make appropriate QTIP election, no prospect of the IRS
using a Rev Proc 2001-38 argument to deny the effect of the election, and the
prevention of a second step down in basis.
Just as importantly, although not extensively discussed herein, if the surviving
spouse’s estate, including the QTIP trust, increases over time above the
survivor’s Applicable Exclusion Amount (including portability), the bypass trust
will almost certainly have saved more in estate taxes than the capital gains tax
savings from getting new (presumably mostly increased) basis.78
Certainly in some situations a marital trust might generate better basis results
than an OBIT. To be more precise, you need to know asset mix, depreciation
info, the date of 2nd death, the beneficiary’s distribution needs, tax
rates/exclusions, inflation, investment turnover, investment returns and more to
make an accurate prediction – all beyond the capability of any mortal being or
computer program.79 The Optimal Basis Increase and Income Tax Efficiency
Trust offers the best bet to optimize tax benefits long-term – all of the benefits
of the traditional bypass trust but with avoidance of most of the drawbacks.
There will be certain situations in which some of these techniques should not be
used. For instance, the common situation in which someone wants to protect the
maximum inheritance for children from a prior marriage and severely curtail the
spouse’s interest – but even then many taxpayers will prefer variations of some
of these techniques (e.g., would a surviving spouse really appoint to his/her
creditors to spite the decedent’s kids and is there an independent trustee (or
other non-adverse party) on the planet that would consent?).
Some people have been reticent to pay attorneys for needed amendments to
planning due to “tax volatility fatigue” and frustration with Congress. The
pitfalls and techniques discussed in this commentary, coupled with apparent
permanency, should give substantial financial incentives for clients to revisit
their estate plan. Moreover, these techniques are simply not available to “do it
yourselfers” or general practitioners – there are no off the shelf, Nolo Press or
online form books for any of these techniques. However, any attorney
specializing in estate planning can adapt these ideas to provide tremendous
value to their clients.
HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE
DIFFERENCE!
Ed Morrow
CITE AS:
LISI Estate Planning Newsletter #2080 (March 20, 2013) at
http://www.leimbergservices.com. Copyright 2013 Leimberg Information
Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any
Person Prohibited – Without Express Permission.
CITATIONS:
No trademark claimed, “Super-Duper Charged Credit Shelter Trust” was apparently unavailable
Section 303 of Public Law 111-312, known as the Tax Relief, Unemployment Insurance Reauthorization, and
Job Creation Act of 2010
3
Rev. Proc. 2013-15
4
E.g. “AB Trust can be hazardous to your health”, “Serious tax consequences to AB Trust owners” “Portability
Threatens Estate Planning Bar”, “Is it time to bypass the bypass trust for good?”, readers have probably seen
dozens by now
5
Frequent Trusts and Estates author Clary Redd at May 2011 Advanced Trust Planning CLE, Dayton, Ohio - to
be fair, he made this comment before the provision was made permanent.
6
$3Million gross gain, assuming $500,000 of gain was realized over time, not counting loss in basis due to
depreciation, $2.5 million times a hypothetical 30% combined federal (23.8%) and state (net 6.2%) long term
capital gains tax – this may be more if collectibles/gold/1250 depreciation recapture, or if the assets were real
estate, one might look at it as depreciation lost and consider the income that could have been offset by the extra
basis, which might drive this estimated loss to beneficiaries even higher (though you would have to back out for
present value). Of course, if heirs never sell the property (and depreciation does not apply) and hold until death,
subsequent taxable gains resulting from decreased basis would be non-existent. In short, it’s a rough
“guesstimate”.
1
2
7
An exception would be plans/IRAs that the decedent had previously inherited and was unable to rollover into
their own name outright (as surviving spouses typically do)
8
For a checklist of reasons why to use a trust and drafting and administration issues to consider if you do name a
trust as beneficiary, email the author for CLE outline and checklist. Also, attorney/CPA Sal LaMendola will
soon publish a superb comparison of IRA/trust options for second marriage situations in an article to be entitled
Estate Planning for Retirement Plan Owners in Second (or Later) Marriages
9
IRC §121
10
For S Corp qualification, including QSST and ESBT, see IRC §1361 et seq., for small business stock
exclusion and rollovers, see IRC §1202 and §1045, for losses on qualifying small business stock see IRC §1244
11
I will avoid the probate/non-probate revocable trust debate, since probate costs and fees will vary from state to
state, but probate avoidance and privacy may be yet another reason. A bypass or marital trust might be a
testamentary trust.
12
A contract to make a will may offer a tempting solution, but there are significant problems with those that
exceed the scope of this paper, such as triggering a prohibited transaction as to retirement plan assets or
disqualifying assets from marital deduction, not to mention various practical enforcement complexities
13
See the Retirement Equity Act of 1984, IRC §401(a)(11), IRC §417(d)(1), Treas. Reg. §1.401(a)(20), Q&A 28
14
Strangely enough, there may be a difference here between a testamentary and living trust. See 42 U.S.C. §
1396p(d)(6); HCFA Transmittal 64 § 3259.1(A)(1)
15
See Treas. Reg. §20.2056(c)-2(e) – had John’s will/trust had an A/B split or QTIPable trust with a
simultaneous death clause stating that Jane is deemed to have survived him that would have overridden the
Uniform Simultaneous Death Act and the IRS would respect the marital trust and hence add enough assets to
Jane’s estate to use both exemptions. When the order of death can be determined, you cannot simply change the
order in the Will/Trust for “surviving spouse” purposes. See Estate of Lee v. Commissioner, T.C. Memo 2007371. If we include a presumption that Jane dies first, will the IRS respect John as a “surviving spouse” for
purposes of DSUEA? Probably, but we have no guidance yet. Temporary Regs do not mention this issue.
16
Clayton v. Commissioner, 976 F.2d 1486 (5th Cir 1992) – decedent’s Will directed that if a QTIP election was
not made for a trust that the assets moved to bypass trust with different dispositive provisions. See also Treas.
Reg. §20.2056(b)-7(d)(3) “a qualifying income interest for life that is contingent upon the executor’s election
under Section 2056(b)(7)(B)(v) [QTIP] will not fail to be a qualifying income interest for life because of such
contingency or because the portion of the property for which the election is not made passes to or for the benefit
of persons other than the surviving spouse.”
17
Example: John really wishes to leave his $5 million estate to his longtime wife Jane outright (ignoring all the
reasons herein for ongoing trusts), but he certainly does not want to lose his exclusion amount, because his wife
Jane also has a $5 million estate. His attorney therefore drafts a savings clause in his Will (or revocable trust)
that leaves his available exclusion amount to a bypass trust, but if a proper estate tax return is timely filed to
exploit the DSUEA (and the will/trust provisions may even require this, though this might give up some postmortem flexibility), the assets instead go outright to his wife to the extent of the election. Thus, if the executor
files the Form 706 timely and successfully “ports” $5 million DSUE, then $5 million goes outright. If the
executor fails to timely file the Form 706 (or opts out), then $5Million goes into a liberal bypass trust for Jane.
Either way, the exclusion is saved.
An independent executor/trustee may be desired here. A surviving spouse would have obvious conflicts
with his or her fiduciary duties to other beneficiaries by filing such an election and potentially gift tax issues as
well, unless the filing were mandated in the document. Even if an independent party is named, it may be best to
outline parameters or indemnify the executor from diverse ranges of elections selected. Will such a provision be
upheld similar to the Clayton case and acquiesced Regulations?
Drafting Example: “I leave my entire residuary outright to my surviving spouse, on the precondition
that my personal representative (or my trustee if no personal representative is appointed, pursuant to IRC § 2203)
makes an effective election on an estate tax return pursuant to IRC §2010(c) [Section 303 of the Tax Relief,
Unemployment Insurance Reauthorization and Job Creation Act of 2010] to grant my wife the use of my
Deceased Spousal Unused Exclusion Amount. Should for any reason (intentional or unintentional), such an
election is not effectively made, or is made for less than maximum amount available, I hereby leave the
maximum amount possible without incurring a federal estate tax to the Bypass Trust described in Paragraph __,
and any remaining residuary above this amount shall pass to my surviving spouse outright”. [I hereby indemnify
my executor from any such election or failure to elect (be it partial, to the maximum extent or not made at all)
made in good faith.] [NB: fractional formula variations on this would be desirable if IRD is involved].
Drawbacks: This technique would be difficult to use for non-testamentary, non-trust assets such as qualified
plans, IRAs etc that pay outright rather than through trusts or wills. Imagine trying to draft such language in a
beneficiary designation form (and getting it approved by a financial institution!)
18
http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/Bonds/P204318- 2% or more jumps happened
several times in the late 70s, early 80s.
19
IRC §1014(b)(6),(9), (10)
20
At IRC §2056(b)(7) and IRC §2056(b)(5) respectively
21
Under IRC § §1014(b)(9), not IRC §1014(b)(10)
22
Treas. Reg. 25.2518-2(e)(2), (e)(5) Example 5 – also need to check various applicable state laws, since, unless
disclaimer is under 2518(c)(3), it has to also comply with state law
23
See, e.g. Estate of Mellinger v. Commissioner, 112 T.C. 26 (1999), acq. 1999-2 C.B. 314
24
See, e.g. Estate of Fontana v. Commissioner, 118 T.C. 318 (2002), IRS FSA 200119013, interpreting Treas.
Reg § 20.2031-1(b), see IRC §754 for inside basis election for partnerhip/LLCs.
25
See, The General Power of Appointment Trust is Back, Bruce Steiner, LISI Estate Planning Newsletter #2060
(February 6, 2013).
26
IRS Rev. Proc. 2001-38, see also PLRs 2009-18014, 2007-29028, 2010-36013, all voiding QTIP election
27
The problem with inter-vivos QTIPs is that, after the death of the donee spouse, if assets come back to the
donor spouse in trust, even though IRC §2044(c), Treas. Reg. §25.2523(f)-1(f), Example 11 would deem the
donee spouse the grantor/transferor for 2036/2038 purposes, under most state laws, the donor spouse is still the
settlor, making the trust self-settled and therefore subject to the donor’s creditors despite any discretionary
standard or spendthrift provision, and therefore in the donor spouse’s estate indirectly under IRC §2041. See
also Rev. Rul 76-103. States that have recently fixed this issue are Arizona (Ariz. Rev. Stat. 14-10505(E)),
Michigan (MCL §700.7506(4)), Virginia, Ohio (effective March 27, 2013, Ohio R.C. §5805.06(B)(3)(b)),
Delaware (12 Del Code 3536(c)(2), Florida (Fla Stat. 736.0505(3))
28
This is known as a collateral power, See Restatement Property, Third, Donative Transfers, §17.3, comment f
29
IRC §2041(a)(3), IRC §2514(d). While it’s very simple to add a limited power of appointment (LPOA) that
would in theory permit this, understanding the DTT involves what may be uncertain state law and considerable
complexity. States such as Michigan and Ohio have recently amended their Rule Against Perpetuities to
specifically prevent most unintentional triggerings of the “trap”, but clearly permit intentional triggerings by
appointing to a trust that has a presently exercisable general power of appointment and therefore triggering IRC
2041(a)(3). See Ohio R.C. §2131.09 (changes effective 3/27/2013), and a comprehensive article on the subject
from Attorney James Spica regarding Michigan’s RAP at http://www.michbar.org/probate/pdfs/Summer08.pdf
30
A rather clever variation that the IRS fought, lost and finally acquiesced to in Chisholm v. Commissioner, 26
T.C. 253 (1956) but beware Restatement of Property, Second, Donative Transfers §13.1(c), which would deem
any LPOA to be a GPOA if the gift in default of exercise were to pass to the powerholder’s estate.
31
See Restatement of Property, Second, Donative Transfers, §13.2 Creditors of the Donee - Unexercised
General Power Not Created by Donee. If creditor protection is a potential threat, and state law is unfavorable,
consider the LPOA/DTT variant.
32
Although the author could find no case on retroactive disqualification of either, consider Estate of Atkinson v.
Comm., 309 F.3d 1290 (11th Cir. 2002), in which a charitable contribution to an otherwise qualifying CRT was
negated by subsequent mistakes in administration years later – even though the charity was not prejudiced.
33
In many cases, I would not recommend that an IRA be used to fund a bypass trust, since a spousal rollover has
better income tax treatment, but it may be preferable when needed to soak up state estate tax exemption, or for
various non-tax reasons. This is mostly included to show the lack of effect on basis on IRD at death. If an
accumulation trust (as opposed to conduit trust) design is used, consider a separate or standalone trust so that no
broad power to appoint can be construed to apply to the retirement benefits. Blanket savings clauses may not
save the stretch, especially since most POAs by default can include non-qualifying trusts. See Restatement of
Property, Third, Donative Transfers §19.14, other IRA CLE materials developed by author and ¶6.3.09, Life and
Death Planning for Retirement Benefits, 6th Edition, by Natalie Choate.
34
If real estate is held in an LLC/LP or other entity taxed as a partnership, the underlying assets do not
automatically get a date of death basis even if the LLC/LP is in the decedent’s estate, but the partnership may
make an election under IRC §754 to step up inside basis. Treas. Reg. §1.754-1
35
Potentially, the QTIP may be worse from this perspective if there is no estate tax, since potentially you have
discounting if, for instance, a QTIP owns half the home and the surviving spouse owns half – this would allow
the heirs less step up in basis than if the surviving spouse had owned the whole.
Treas Reg. §20.2041-1(b)(3) states that “(3) Powers over a portion of property. If a power of appointment
exists as to part of an entire group of assets or only over a limited interest in property, section 2041 applies only
to such part or interest.” There are probably dozens of cases and rulings about limiting powers and funding
trusts with “caps” a few in the GPOA context are PLR 2001-23045, 2000-101021, 2002-10051, 2004-03094,
2006-04028
37
IRC §1022
38
See IRS Chief Counsel Memorandum (CCM) 200644020, Treas. Reg. §1.1014-4(a)(3), although, in contrast
to IRA/see through trust planning with IRD assets, presumably the result here would be less harsh, since assets
would get a step up in basis and hence less gain. However, it is best to avoid altogether.
39
If the power to withdraw 1/3 had lapsed, 5% might be “lapse protected”, causing slightly less to be in the
beneficiary’s estate (and thus less basis adjustment).
40
Restatement, Third, Property, Wills and Other Donative Transfers §17.1
41
See comment g in §17.1 cited above
42
The example did not specify whether the property TIC or LLC shares in trust was 100% or a mere fractional
share. I assume here that taking 5/6 of the property is valued at 5/6 of the whole, which might be the case if the
trust owned say 40%. If the trust owned 100% or 51% of the LLC, it may apply to a greater number of
shares/membership interests.
43
See, Gifts by Fiduciaries by Tax Options and Elections, November/December 2004 Probate and Property, by
Jonathan Blattmachr, Stephanie Heilborn and Mitchell Gans, for a good discussion of gift tax effects of
interested fiduciary decisions regarding Clayton QTIPs, investment choices, alternate valuation date, choice of
where to deduct expenses and other dilemmas, concluding that independent fiduciaries are generally safer, but
citing Treas. Reg. §25.2514-1(b)(1) for apparent safe harbor for investment choices by interested fiduciary.
44
Ohio’s former estate tax, eliminated this year, failed to catch the Delaware Tax Trap (R.C. §5731.11), but most
states piggy back onto the federal estate.
45
IRC §2056(b)(5) – though generally the whole purpose of the OBIT is to avoid forcing the marital, it’s
important to remember. This language is also why you can’t simply let 5% of a GPOA lapse every year to let
the marital trust escape estate tax altogether after 20 years or so.
46
IRC §2041(b)(1) is in the disjunctive “or”. See also Estate of Edelman v. Commissioner, 38 T.C. 972 (1962),
Jenkins v. U.S., 428 F.2d 538, 544 (5th Cir. 1970)
47
IRC §2041(b)(1)(C)(ii), Treas. Reg. §20.2041-3(c)(2)
48
To be adverse, the party must have a “substantial interest in the property subject to the power which is adverse
to the exercise of the [GPOA]”. An independent bank co-trustee, for example, is not sufficiently adverse. Estate
of Vissering v. Commissioner, 96 T.C. 749 (1971), reversed on other grounds, Estate of Jones v. Commissioner,
56 T.C. 35 (1971), Miller v. United States, 387 F.2d 866 (1968).
49
Treas. Reg. §20.2041-3(b)
50
See PLR 2012-03033, and discussion thereof in separate IRA “see through trust” checklist CLE materials
developed by author. This PLR addressed the effect of such a limitation for “see through trust” purposes of
identifying the oldest beneficiary applicable, but it did not discuss whether after such a limitation the power was
still a GPOA. Pursuant to the plain language of the statute and Regs, it still is, but at some point you have to
wonder whether the IRS would argue it is illusory – how many creditors out there are young individuals?
However, the vast body of case law and regulations bend over backwards to find GPOAs. Like horseshoes and
hand grenades, you only have to be close – if you give a mentally incompetent person a GPOA they don’t even
know about, it’s still a GPOA for tax purposes. One related area the IRS has fought related issues is in the
Crummey and Cristofani present interest cases, where the IRS insists on a GPOA powerholder’s knowledge for
there to be a present interest (Rev. Rul. 81-7) – but they consistently lose cases in this area even with shoddy
trust administration.
51
IRC §1014(c), IRC §691
52
Otherwise, a powerholder could simply borrow $1 from anyone and/or promise to pay unlimited amounts in
exchange for some peppercorn of consideration to attempt to enable an appointment of all the assets to
whomever they wished. However, such shenanigans to circumvent the class of appointees may be voided as a
“fraud upon the power”, see Restatement of Property, Third, Donative Transfers, §19.15, §19.16
53
See Restatement of Property, Second, Donative Transfers, §13.2, §13.4 (state law), §13.6 (bankruptcy, which
could be applicable if decedent was in bankruptcy prior to death) – best to check those for citation to your
individual state law. If your state law is unfavorable, it may be preferable to use the Delaware Tax Trap
technique, which uses limited powers of appointment only.
36
54
See also Treas. Reg. §20.2041-3(e)
Using the Delaware Tax Trap to Avoid Generation Skipping Transfer Taxes, Johnathan Blattmachr and Jeffrey
Pennell, 68 Journal of Taxation 242 (1988), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1954062. While
the DTT was not considered or discussed for this type of planning, this is not the fault of two of the sharpest
estate planning minds in the country, rather, the exclusion was only $600,000 at the time. See also A Practical
Look at Springing the Delaware Tax Trap to Avert Generation Skipping Transfer Tax, James P. Spica, 41 RPTL
Journal 167, Spring 2006; The Delaware Tax Trap and the Rule Against Perpetuities, Stephen Greer, Estate
Planning Journal Feb 2001.
56
See discussion in articles in above footnote, specifically Footnote 17 in Pennell and Blattmachr’s article cited
above, wherein they opine that this would trigger the DTT under most states’ RAP.
57
Contrast presently exercisable GPOAs in Restatement of Property, Second, Donative Transfers, §13.2 and
§13.5 with the testamentary variations in §13.4 (state law), §13.6 (bankruptcy). Testamentary or Lifetime
GPOA makes a difference in bankruptcy. See 11 U.S.C. § 541(a)(1). No cases discussed in the above
Restatement cases discussed the impact of a non-adverse party’s consent, notice or other prerequisite’s impact on
creditors’ rights.
58
IRC §1014(b)(6)
59
Alaska Statute § 34.77.100 et seq. for how one may elect into community property treatment for low basis
assets using an Alaska Community Property Trust (and avoid such treatment for problematic assets such as IRAs
or assets with higher basis than FMV). See, The Tax Advantages of Using Joint Revocable Trusts and Alaska
Community Property Trusts in Common Law Property States, http://shaftellaw.com/article15.html, Alaska
Enacts an Optional Community Property System which Can be Elected by Both Residents and Nonresidents, by
David Shaftel and Stephen Greer, http://shaftellaw.com/article3.html
Blattmachr, Zaritsky and Ascher, Tax Planning With Consensual Community Property: Alaska's New
Community Property Law, 33 Real Property, Probate and Trust Journal 615 (1999).
Disclosure: the author’s employer, KeyBank, has trust powers and operations in Alaska.
60
See PLRs 2000-101021, 2002-10051, 2004-03094, 2006-04028 – nutshell: giving poorer spouse a GPOA over
assets of richer spouse that could fund a bypass trust for richer spouse at poorer spouse’s death. In most cases
the richer spouse would be better off funding an inter-vivos QTIP, transferring non-controlling LLC interests or
other intervivos gift-splitting to harvest a poorer spouse’s GST exclusion. Notably, most practitioners including
this author believe those rulings are incorrect in their holding that transfers from richer spouse to poorer spouse’s
estate qualify for the marital deduction under IRC §2523. See Clary Redd’s article Sharing Exemptions? Not So
Fast, Trusts and Estates, April 2008. However, other aspects of those rulings are non-controversial, and include
the idea of capping a GPOA to an amount able to be soaked up by an appointee’s available applicable exclusion
amount – a key feature in this article that the IRS seems to have no problem with.
61
Uniform Trust Code §505(b)
62
It’s great for very large estates, if you use a state with appropriate intervivos QTIP protections, see Jonathan
Blattmachr, Mitchell Gans and Diana Zeydel’s Supercharged Credit Shelter Trust article at
http://eagleriveradvisors.com/pdf/The-Supercharged-Credit-Shelter-Trust-A-Super-Idea-for-MarriedCouples.pdf. See Footnote 27 for citations to state law in this area.
63
Treas. Reg. §1.671-2(e)(5), Example 9
64
Ohio RC §5805.06, effective 3/27/13, “intended to be a statement of the common law of this state”
65
Commissioner v. Estate of Bosch, 387 U.S. 456 (1967) held that a state trial court decision as to an underlying
issue of state law should not be controlling when applied to a federal statute, that the highest court of the state is
the best authority on the underlying substantive rule of state law, and if there is no decision by the highest court
of a state, then the federal authority must apply what it finds to be state law after giving “proper regard” to the
state trial court’s determination and to relevant rulings of other courts of the state. It does not say to ignore state
law, as some practitioners fear. For one of several cases denying the marital deduction for attempts at a postmortem “fix” or relying on marital savings clauses, see Estate of Rapp, 130 F.3d 1211 (9th Cir. 1998)
66
Although taxpayers can argue that September 30 of the year after death should be the important date to “fix” a
see through trust by, and I would still argue this in clean up mode, the IRS could argue that, except for
disclaimers that “relate back”, the Code and Regulations require there to be a beneficiary named by the
owner/employee pursuant to the terms of the plan and/or default under agreement to obtain status as a
“designated beneficiary” at the time of death, and if the trust changes terms significantly after that, it is arguably
not the same beneficiary post-reformation that it was at the time of death, hence no DB, even if effective for nontax law. IRC §401(a)(9) and Treas. Reg. 1.401(a)(9)-4, A-1. See PLRs 2002-18039, 2005-22012, 2005-37044,
55
2006-08032, 2006-20026, 2007-03047 and 2007-04033 (allowing reformation to affect tax result at death for
IRA/trust), and PLRs 2007-42026, 2010-21038 (contra).
67
Rev. Rul. 73-142
68
Treas. Reg. §20.2041-1(b)(1), Rev. Rul. 95-58
69
PLR 2005-43037
70
IRC § 2514
71
PLR 2011-32017
72
IRC §643(a)(3), Treas. Reg. §1.643(a)-3(a)
73
This should not cause estate inclusion, nor a taxable gift, if it is properly circumscribed with support obligation
savings clause provision to forbid distribution to someone whom the donee powerholder owes an obligation of
support. See Treas. Reg. §20.2041-1(c)(1)(B). It could trigger a gift if exercised so as to trigger the Delaware
Tax Trap, discussed elsewhere herein. IRC §2514(d).
74
See IRC §642(c)(1) and Regs. The Supreme Court held in Old Colony Trust Co. v. Commissioner, 301 U.S.
379 (1937) that “pursuant to the governing instrument” in IRC §642(c) plainly includes discretionary
distributions, and need not be pursuant to a mandatory direction. There is some uncertainty, however, from
narrower lower courts, and how this may play out using POAs rather than distributions from the trustee pursuant
to a spray provision. Generally, you would be more secure in getting the 642(c) deduction the more direct,
certain and specific the trust provision is. See discussion of 642(c) nuances in Chapter 6.08 of Federal Income
Taxation of Trusts, Estates and Beneficiaries by Ascher, Ferguson, Freeland. It is questionable whether a POA
can even carry out income, since it is a power over specific property, so it is quite different from a spray
provision. However, a lifetime LPOA has efficacy as both a backstop and threat to the trustee’s spray power and
as an alternative method of transferring property subject to differing tax results. If the powerholder is a
mandatory income beneficiary however, it would be deemed a gift of the lost income, and if the powerholder
also has a testamentary GPOA it would be considered a gift as well. Estate of Regester, 83 T.C. 1 (1984), Treas.
Reg. §25.2514-1(b)(2). This may not be fatal, but for these reasons as well as income tax planning, an
independent trustee’s spray power over income and principal should be preferred over using lifetime LPOAs.
75
Treas. Reg. §1.642(c)-1(a)(2)
76
Treas. Reg. 1.642(c)-3(b)(2), and Ex. 2
77
Thresholds for single and married filing jointly couples to incur the top 39.6% and 20% long-term capital
gains and qualified dividends rates
78
For the wealthy, a QTIP bequest with full DSUEA elected and reverse QTIP election would probably always
beat a standard bypass trust for wealthy married couples if the surviving spouse then immediately funded via gift
a maximum (e.g. $10.5 million in 2013) irrevocable grantor trust (or released a portion of the QTIP to trigger
IRC §2519). This could then potentially exploit installment sales, swaps, etc. Using intervivos QTIPs or grantor
trusts funded via gift after the first death enable the use of pre-estate tax dollars to pay the income tax burden of
the grantor trust. This will work, at least until the Obama Administration closes the grantor trust “loophole” per
its 2013 Greenbook proposals (page 83). Most couples of such wealth have already used the gift tax exclusion
during their lifetime, but those who haven’t should strongly consider that technique.
79
For illustrations of this savings if investment returns net approximately 11% and the surviving spouse lives 15
or 30 years, see Gassman, Crotty, Buschart & Moody On the $28,000,000 Mistake: Underestimating the Value
of a Bypass Trust and Overestimating the Value of Spousal Estate Tax Exclusion Portability, Steve Leimberg's
Estate Planning Newsletter #2061. While I may disagree a bit with some of the assumptions, the general thrust
of the article/spreadsheets is in the right direction and makes a powerful point.